OT (?) Profit margins

OT, or not OT because margins affect the value of Berkshire’s holdings?

It seems in my relative ignorance that the valuation of [BRK-A/S&P 500] is either reasonable or unreasonable depending on one’s opinion on the sustainability of recent profit margins. Traditional valuation metrics like CAPE and Tobin’s Q have been famously elevated for most of the past couple of decades, leading some people (like me) to be near-permanent bears and nearly permanently wrong.

As near as I can tell, what has enabled those bearish indicators to be so consistently wrong–in addition to fed policy–is ever growing profit margins. See for example https://www.yardeni.com/pub/sp500margin.pdf. I think traditional economic theory expects profit margins to be mean-reverting. But if that’s true, it’s taking its sweet time. So two big questions:

  1. What is driving the expansion of profit margins? and
  2. Can we expect them to plateau, continue to increase, or revert toward historical means (over, say, the next decade or two)?

Here are a few candidates for the cause of the expansion:

A. Business-friendly tax policy, e.g., the Trump tax cuts.
B. Decline of labor’s power relative to capital.
C. Movement of the economy to high margin businesses including effective monopolies (Google, Facebook).
D. Low cost of borrowing.

What do you all think–why the historically high and growing margins, and where are they headed in the future?

2 Likes

A. Business-friendly tax policy, e.g., the Trump tax cuts.
B. Decline of labor’s power relative to capital.
C. Movement of the economy to high margin businesses including effective monopolies (Google, Facebook).
D. Low cost of borrowing.

That seems to be a good list.
They all net down to this: a growing share of GDP going to net company profits relative to the other possible destinations.
Notably, labour and tax.

A big factor is globalization: until the last few decades, most labour in advanced economies did not have to compete with labour in other places.
When you think about it, that was a bit of an anomaly: why should a blue collar worker in Detroit
expect to be able to make enough in an hour to buy at Walmart goods that took some other blue
collar worker somewhere else seven hours to produce? Three gross of little paper umbrellas, say.
Thought of that way, it was perhaps an unsustainable situation from the get-go.
Maybe the high share going to labour was an historical quirk. Beats me.

What do you all think–why the historically high and growing margins, and where are they headed in the future?

I view it as two things combined.
There is the absolutely completely predictable business cycle. Margins vary a lot cyclically because of operating leverage:
a 10% drop in sales is likely to cause a 30%+ drop in profits at the average firm.
Net margins will tank each time the cycle turns.

This simple cycle is superimposed on a long term wandering line.
It is technically mean reverting because we know net margins won’t be above 100% or below 0% even a thousand years from now: it is forever bounded.
But it is not cyclical. It can go to a highish level for an arbitrarily long time, or a lowish level, unpredictably.
As far as I can tell, it seems to be based primarily on the relative power of labour, capital, and government.

So, where will it go next?
The cycle will do what the cycle does.
But the bigger long term line?
Personally I think some numbers for net margins are in the vicinity of about as high as they can go.
Maybe a few percent more, but I assume there’s a limit.
But I have no idea whether it will (ignoring the recession cycle) stay at that high level or fall back.

Note, a lot of these things that make sense from first principals only work if you consider the global economy, not the US in isolation.
For example, you often hear a lot of hand wringing about low capex in recent years, in the US or some other specific rich country.
But globally, there is no such effect. There has been unimaginable capex in China and some other places.
So, like capex, the issue of profitability of a few big companies (your item C above) might not really be a thing.
Globally there are some very profitable companies, but also thousands of very modestly profitable ones.
What we’re really seeing is that we’re looking in only one place, and that one place has a slightly disproportionate number of the first type.
Globally, I don’t think profitability is soaring.
Globally and over time, tautologically the weighted average return on capital has to equal the weighted average cost of capital.

If global returns on capital were so high, we would axiomatically have to be seeing very high cost of capital.
Does anybody think that describes the last 10-20 years of the global economy?

Jim

9 Likes

As far as I can tell, it seems to be based primarily on the relative power of labour, capital, and government.

Yes, and it seems in the US that power has tilted toward capital over the past 40 years. And that could continue for another 40 years, or it could change dramatically within the next ten years. Who can say.

Thanks for your thoughtful response.

What do you all think–why the historically high and growing margins, and where are they headed in the future?

Mine is decidedly a minority opinion in the universe of finance/econ analysis, but I believe in general that folks in those silos become wedded to historical statistical models without necessarily appreciating the impacts of larger, exogenous trends, especially in politics.

(As an aside, this myopia is reflected in some China analysis today, where otherwise intelligent people apply the laws, such as they are, of economics and finance and seem surprised when a totalitarian dictatorship upsets these calculations by fiat.)

Exploring these trends requires skiing uncomfortably near the trees here. Conclusions that might seem fair and objective in a political science class are likely to be read as partisan and argumentative on an internet message board. So, for whatever it’s worth, I intend the following observations to be as close to objective analysis as I can come.

The 5-4 decision by the U.S. Supreme Court in Citizens United v. FEC 12 years ago – judicially declaring money in politics to have the protection of speech under the First Amendment and practically allowing big money to flood the political system – capped a realignment of economic interests that perhaps began when President Reagan broke the air traffic controllers’ strike in 1981. This period resulted in enormous gains for capital and enormous losses for labor.

It is no longer controversial to observe that corporate lobbyists, who vastly outnumber legislators, write many U.S. laws, most notably an impenetrable federal tax code that has allowed, for much of that time, headline corporate tax rates and effective corporate tax rates to enjoy the marginal connection of distant relatives. Nor is it particularly controversial to observe that, in the main, politicians’ chief incentive is to remain in office, and catering to corporate deep pockets is a most effective way to achieve it.

These trends have had a variety of effects. They have allowed U.S. corporations to become the biggest and best in the world. The loss of labor’s leverage, generally blamed on globalization, dropped straight to the bottom lines of companies that traded collectively-bargained wages in the U.S. for Mexican or Chinese or Vietnamese wages. Automation, technology, accelerated this redistribution of wealth from labor to capital.

One could also argue that these trends contributed to the hollowing of the middle class and the resulting political trends of populism and alienation we see today. These effects may not seem material to the question you pose, but they suggest a destabilization of the economic platform that provides these generous profit margins.

Viewed through a poly sci lens, I would hazard a guess that the pendulum has swung about as far toward corporate interests as it can without causing a political upheaval that would jeopardize the entire system. Political destabilization is already evident. Nostalgic U.S. historians yearn for a response similar to the one Teddy Roosevelt brought to the Gilded Age, but there is little evidence today of TR’s famous sense of noblesse oblige.

Over the short course of U.S. history, political trends such as this have tended to be cyclical, but the cycles have been very long, multi-generational, and the data set is too limited to suggest what comes next, especially considering all the new variables introduced by the digital age. For those of us nearer the end than the beginning of our timelines, it seems to me imprudent to expect profit margins to revert to levels that reflected very different political and socioeconomic realities.

78 Likes

Spot on.

1 Like

Mine is decidedly a minority opinion in the universe of finance/econ analysis, but I believe in general that folks in those silos become wedded to historical statistical models without necessarily appreciating the impacts of larger, exogenous trends, especially in politics.

The summary is spot on.

The reasoning is way way over indexed on just one out of many many factors.

I would hazard a guess that the pendulum has swung about as far toward corporate interests as it can without causing a political upheaval that would jeopardize the entire system. Political destabilization is already evident.

Warren predicted these political issues in 1999:

“In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%… If corporate investors, in aggregate, are going to eat an ever-growing portion of the American economic pie, some other group will have to settle for a smaller portion. That would justifiably raise political problems”

10 Likes

Buffett and Munger have said something to this effect: some thing are unimportant; some things are important but unknowable; some things are important and knowable.

This thread has been interesting and thoughtful.

And seems to suggest that this issue of profit margins fits best into the middle category.

So what to do as an investor?

I too have left too much capital on the sidelines too often as seemingly historically validated data indicated the market was too overvalued, and most of the wonderful businesses I’d want to own seemed that way too. Lately I’ve decided to give up on that, and simply put all of my focus solely on picking the best handful of available businesses (of course also weighing the price) at any given time, thereby remaining basically fully invested. This capitulation…I mean insight is, of course, a wonderful indicator that a huge market crash is coming :slight_smile:

That being said (the inherent unknowability of the profit margin situation), I think if profit margins writ large start to revert substantially toward the mean, then it will be less painful to be in the best businesses, with the best profit margins and ROIC. Or if they don’t mean revert, then it will be best to be in those businesses as well. This is exactly how I address the potential for horrible inflation; it is important, but unknowable, so I chose those special businesses that will likely be the best in any situation.

6 Likes

I too have left too much capital on the sidelines too often… Lately I’ve decided to give up on that… This capitulation…I mean insight is, of course, a wonderful indicator that a huge market crash is coming :slight_smile:

It’s not just what you what but WHEN you do it that might support that, as you are giving up in a time with finally, after them being artificially low “forever”, rising interest rates. Maybe the worst possible time to come to those new “insights”.

1 Like

@ultimatespinach:

Thank you for daring to ski close to the trees. Remarkably, so far nobody has thrown shade your way for it. I think your analysis is spot on. I would add only that change, when it comes, sometimes comes suddenly. Particularly in an environment that has been destabilized. But whether change in this respect will come suddenly or gradually, soon, or not for a long time–not easy to predict.

2 Likes

It’s not just what you what but WHEN you do it that might support that, as you are giving up in a time with finally, after them being artificially low “forever”, rising interest rates. Maybe the worst possible time to come to those new “insights”.

I don’t disagree.

But, remember, I’m not buying “the market”. Only a small handful of businesses. Two of these I think will benefit from higher interest rates. One is Berkshire Hathaway; it will get better returns on the T-bills, and it hopefully makes business/stock acquisitions at a better valutations.
In a similar vein, Constellation Software is similar to Berkshire in that all of its free cash flow goes into buying more businesses; it too should find better pickings in an environment of higher interest rates. These two represent more than 40% of the portfolio. Another holding, Franco-Nevada, will actually to much better in a sustained inflationary environment (though it has done quite well in low inflation periods too) which would likely be associated with a rising-rate environment.

1 Like